Broadband Services - Success Second Time Around

Broadband services are back at the financing trough -this time
with their hunger for growth financing backed by adequate consumer
and small business demand. Global capital markets will be asked for
more than $100 billion of broadband network construction funding
over the next three to five years. Individual projects to be
financed include several global broadband satellite systems at
$10-20 billion each, several trans-oceanic cables at $3-10 billion
each, and a handful of global terrestrial broadband networks at
$5-10 billion each, as well as both wireless and wired access
networks in most major countries at $1-5 billion each.

However, broadband networks were a uniform failure for telcos
earlier this decade, as demand failed to develop for the initial
set of broadband services. Abandoned projects amounted to more than
$20 billion world-wide. They included numerous failed trials, two
partnerships with Hollywood for content, and several wireless LMDS
or CATV acquisitions. Key equipment and software suppliers such as
Microsoft, Hewlett Packard, Nortel and Silicon Graphics also wrote
off major product development projects, when orders did not
materialize.

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Leaders of major telcos, equity investors and key lenders are
now pondering whether this generation of broadband services and
their associated broadband networks will be more successful than
the last and are asking what the key drivers of demand will be.
Recently, apparent problems with demand and network start-ups in
the adjacent business of global voice satellite services have
heightened their concerns.

Based upon analysis of these issues for numerous clients, we see
broadband services poised for major success this time. Depending
upon a company's starting position, one of several distinct
competitive strategies will garner a broadband service provider
healthy results, once this market takes off.

Background
The launch of first generation broadband services was fuelled by
grossly optimistic demand forecasts, but stalled on uneconomic
equipment costs and false expectations about the actual services to
be used. Assessing future demand has been the Achilles' heel of the
telecoms industry. Starting with video-phones in the 1960s,
followed by ISDN services in the 1970s and 1980s and later
broadband services in the 1990s, actual demand for new services has
often fallen far short of projections.

Fortunately these investments did not become financial disasters
for shareholders, since the industry was regulated into the rate
base. However, under new open market conditions, similar failure
could result heavy losses. These early-stage projects stumbled in
part, because they launched with new technology relying upon an
over-optimistic picture of user needs. Market research was often
targeted only at early adopters and was used for what were more
appropriately venture capital type decisions, given the early stage
of market development. Software and hardware vendors only
exacerbated this problem, energizing network technologies early on
by hyping hoped-for access capabilities. Corporate broadband demand
estimates were closer to the mark, because they did not require
deployment of new access technologies.

These factors all played a role in the poor decisions
surrounding broadband services earlier this decade. Suppliers
oversold their ability to facilitate broadband access and related
SONET transport at reasonable costs. Early market research verified
limited demand for broadband services at prices required to break
even, but forecasters then presumed that consumer attitudes would
change, once services were deployed and better understood by users.
Some management teams downplayed initial profitability estimates
and/or circumvented them, citing the potential of other,
still-emerging technologies, such as digital LMDS.

Other telco leaders proudly announced major network visions and
presented them to regulators and unions for approval. In addition,
competitive pressures from the threat of CATV firms providing
telephony and computer services through cable modems heightened the
need for prompt decisions and announcements. Entering CATV through
broadband services was rarely attractive on its own, given
predictions of broadband's low growth and low profitability outside
of content. But the move appeared attractive to telcos on an
incremental basis because of projected cost sharing and prospects
for meaningful, long-term revenue growth, given the size of the
potential market.

Overall, the initial launch of broadband services was marked by
too little critical analysis, too much haste and too much optimism.
The implementation of broadband services also proved troublesome.
They were envisioned in the early 1990s as a combination of the
following: entertainment, such as video-on-demand, pay-per-view,
basic cable, and inter-active games; work-at-home services, largely
high-speed dial-in modem access; on-line services, such as
CompuServe, Prodigy and AOL; and home shopping. Yet little was
really known about end-user preferences and several surprises
emerged from early user trends. These included: limited appetite
for video-on-demand of, say, two to three movies a month/consumer;
lower than expected home shopping volumes in other categories,
indeed low enough to be exceeded by postage stamp sales; and
higher-than-expected volumes associated with X-rated materials
(which some telcos wanted to avoid completely).

User equipment was also a source of problems. Only a minority of
homes had PCs: in addition, many of the PCs were poorly equipped
for high-resolution graphics. TVs were often too small in screen
size to create a home theatre experience, while broadband services
merely substituted for low-tech VCR tape rentals. Receiver boxes
were not standardized and many had to be purchased by the user.
Connection sharing among multiple users in an office or a home was
difficult or impossible.

Lastly, the cost of broadband services required prices too high
for most users, with no relief foreseeable from increased sales
volumes. Consumers thought of broadband services as a substitute
for a $20-$30/month CATV bill, a $2-$10/month pay-per-view bill and
a $20/month computer access charge - or a total of $40-$60 monthly
expenditure. Instead broadband service profitability required a
monthly charge in excess of $100 a month to account for the full
costs of equipment and content, in view of the projected low
penetration levels.

Market conditions
Fortunately, most of these factors have changed for the better.
Today's outlook for broadband services is overall much more
favourable. Corporate broadband demand continues to grow rapidly.
Now small business and consumer demand is sizeable and growing
rapidly. First of all, consumers now know, in some detail, the
value of higher-speed access and seem willing to pay more for
service. Current price levels for broadband services are
profitable, given equipment and operating costs. Accordingly,
start-up capital is available for new competitors.

The market for broadband services is being driven first and
foremost by the Internet. Consider its impact: cost-effective,
high-speed access to the Internet is in high demand from small
businesses, home workers, and middle-income to affluent consumers.
In addition, Internet users can knowledgeably judge the value of
high-speed access to the world-wide web and other information
services. The deployment of powerful PCs in homes and businesses is
widespread enough, so that most users only need a new
receiver/modem.

There are enough varied and valued uses of these services, such
as information, shopping, financial transactions, games, education,
e-mail and others, that most users now feel that they need such
services. Awareness and interest has developed to the point that
commercials for broadband services have replaced PC commercials
during Super Bowl games. The vast majority of users now spend $20
to $40/month for 56 Kilobit access. Many would readily pay up to
$100/month for dependable, high-quality and high-speed service.

World-wide consumers now need faster access, have the ability to
value it and are willing to pay the required price. Upper-income
residents of Brazil, Korea, or Switzerland are just as
knowledgeable as home-owners in the Silicon Valley. The global
information network of the computer industry; including books,
shows, courses, magazines and press coverage, has featured
broadband services for over a year.

Fortunately, today's access equipment can provide relatively
rapid access for just $50 to $100 a month. Cable modem (256
kilobits/sec to 1.5 megabits/sec), XDSL (110 kilobits/sec to 1
megabit/sec), satellite down-links (400 kilobits/sec) and wireless
access (up to 1.5 megabits/sec) are all available at these prices,
depending upon local geography, physical plant conditions and
regulatory authorizations.

However, increased access speed represents only half the
picture. As valuable as high-speed access is to users, it will not
alone increase overall transmission volumes. In fact, it may worsen
service near-term by increasing peak traffic levels on transport
networks. Higher-speed access must also generate a higher volume of
traffic for network projects to be financially successful. Certain
activities (such as checking the weather or ordering a book) occur
faster, but not necessarily more often or in greater detail.

Other activities (such as e-mail) tend to generate larger files
and thereby place additional demands on transport owing to more
attachments. Higher speed enables certain new data-intensive uses,
such as streaming video or full screen 3-D graphics. It also
enables a more sophisticated and insightful portrayal of data (for
example www.smartmoney.com/ marketmap, which provides a visual map
of the stock market by segment that updates in real time, expanding
or contracting elements of the visual display, based on actual
market conditions).

The separate value of higher-speed transport is less clear to
end-users. It is now bundled into their monthly price for service
and is hard to track separately. Bottlenecks in access, local or
long-haul transport all feel the same to most users. However, those
few consumers with multiple access options (satellite, modem, ISDN,
ADSL or cable modem) rapidly assess differences in overall speed
and quickly factor this into their usage and purchases.

This combination of proven price points, acceptable equipment
costs and increasing demand for high-speed access has created
conditions under which greenfield start-ups (Covad and Teledesic
for example) are attracting capital. This trend confirms the
expected profitability of this maturing market.

The overall result of these favourable conditions is massive
capital inflows for new broadband networks and service, an
explosion in the number of competitors and rapid technological
improvements in equipment and services. These conditions have also
triggered major strategic moves by significant players. For
example, IBM has exited the broadband market by swapping lines of
business with AT&T. Meanwhile, AT&T has accelerated its
entry into the access market by acquiring TCI and launching the
first of many expected global alliances with British Telecom.

Future trends
Clearly the current generation of broadband services is poised to
create a major new market. Both today's and future generations of
broadband services will continue to be viewed by users as
delivering good value - much the way cellular services have been
viewed for the past decade. The transition into a mass market will
be completed with widespread adoption of broadband services for
both business and home use. Broadband services should continue
growing in terms of both quality and quantity. Expect to see
near-term success for streaming video, voice-over-IP and
Internet-based commerce. And expect to see prices ranging from $50
to $100 a month, with increasing speed and quality of service at
each price point as equipment costs decline.

Competitors will add capacity, both in access and transport, as
quickly as they obtain financing. Some capacity additions will be
massive, such as the start-up of a global satellite system, but
others will be incremental, route by route, geography by geography.
Competition will focus on three areas: local access and customer
control; wholesale transport both globally and locally; and
globally branded bundles of access and transport from a few
dominant suppliers.

Near-term risks will shift from shortfalls in demand to managing
capacity and costs. Investors will need to be sure that they back
the right technology choices, that the networks are built in the
right places and that over-capacity situations are avoided. The
long-term returns realized from investments in broadband networks
will depend less upon being a first-mover or technology leader and
more upon traditional factors of customer retention and control,
overall scale and branding.

As such, there should be three types of successful business
strategies in the market long term: the first strategy will be to
offer consistently the lowest cost by adopting only proven and
standardized technologies, featuring price-based promotions and
advertising and offering minimal customer support or service - the
Southwest Airlines of broadband services. This position is being
pursued in transport by Level 3 and Qwest.

An alternative strategy is to emphasize overall value at an
acceptable price. This strategy is strengthened through unique
features, content or bundling with other services and products. In
some ways AOL, Equant, Microsoft, and @Home are all executing this
strategy. The last strategy is to develop scale and brand advantage
to overcome price, feature or quality shortfalls. AT&T and AOL
are both pursing versions of this strategy.

The breadth of strategic options will present many telcos with a
strategic challenge. Most telcos have been the first to bring
broadband services to their markets, but they often did so while
retaining their reputation for high prices, slow and inconsistent
service and lack of entrepreneurship or motivation. Now many of
these telcos already face immediate competition from CATV,
satellite and wireless broadband competitors for this next
generation of broadband services.

Soon telcos will also need to address the issue of scale,
service differentiation and the provision of access to Internet
sites outside their territory. Fortunately these same skills and
issues are already being addressed to compete with competitive
access providers (CAPS) and competitive local exchange carriers
(CLECs).

Conclusions
The broadband networks now seeking financing are very different
than those of the early 1990s. Demand has surged, access has
changed and the costs of equipment and content have dropped. These
networks will now find it much easier to produce a profit.
Strategic imperatives will shift from demand creation to capacity
and cost management and customer retention. Operators and suppliers
should all find this market profitable over the next few years. And
this time around financiers should take note of a high reward for
their capital at a lower risk.